27 May 2021

Global: Close to
peak USD liquidity
abundance! Receive
5yr EURUSD xCcy basis
Andreas Steno Larsen

The surge in the ON RRP usage may hint of an upcoming peak in USD
liquidity abundance as the TGA will be rebuilt in Q3. It looks more and more
like a bargain to receive EURUSD 5yr xCcy basis as a combo of a tactical trade
and a macro hedge.
The surging ON RRP usage (liquidity withdrawing facility) could be an early sign that we are about to reach
peak USD liquidity abundance price eect in markets as USDs added from now on will likely not impact
marginal pricing in USD funding markets to the same extent as seen earlier. We hence find good value in
receiving 5yr EURUSD xCcy basis (Target: -25 bps, S/L: 2 bps) as a combination of a USD liquidity / tapering
bet and an inflation macro hedge.

A surging ON RRP activity due to abundance of reserves compared to

collateral
USD liquidity is back in the limelight! In September 2019 a lack of excess liquidity (compared to regulatory
requirements) suddenly led to a spike in repo rates, while the issue is now the exact opposite. The market is
flooded with reserves relative to collateral, why SOFR and bills are trading at the zero-point. As the banking
system is already over-flooded with reserves, the newly added reserves turn into a hot potato that no-one
wants to hold and therefore bills tend to "catch a bid" (potentially into negative territory).

The ON RRP (Fed selling Treasury securities O/N in the TOMO) disincentivizes price action below the zero-
point. The Fed has recently increased the incentives to participate in the ON RRP facility via relaxing the
participation criterias and increasing the cap per counterpart in the facility, and here we are with a surging
volume.

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Chart 1. ON RRP usage surges when reserves are in abundance relative to collateral

The Fed is likely to address this issue via a hike in the IOER by 5 bps at the June meeting, while it also seems
likely that they will relax the access barriers to the ON RRP facility even more to further disincentivize price
action below zero in the USD funding market and to ensure a broad transmission mechanism as the IOER is
not available to all relevant counterparts.

The Fed is likely to start tapering already in September, in our view, but the reason is a roaring comeback in
the real economy, not operational issues such as the flood of reserves relative to available collateral. There is a
clear risk that the May inflation report will prove to be an absolute shocker (published 10th of June) with e.g.
used cars and trucks up by 50% year over year, and a potential further increase in the yearly increase in the
rent of shelter component. Don’t rule out >4% core CPI inflation, which will increase the tapering pressure on
the Fed even more.

Chart 2. 50% surge in used car prices year over year – core inflation above 4% in May?

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Peak liquidity momentum is around the corner
Generally, the US Treasury still expects to increase liquidity until July 31st as the “Treasury is assuming a
cash balance of approximately $450 billion at the expiration of the debt limit suspension on July 31 based
on expected outflows”. This usually transfers in to a cheaper USD funding in a fairly mechanical way, while
one could note that a sort of “stealth QT” is on the table in Q3, as the US Treasury expects to rebuild the
TGA to levels around 750bn by the end of September – zapping liquidity by around 300bn in Q3 along the
way, which paired with a potential tapering announcement from the Fed in September could prove to be an
important turning point for USD liquidity.

We expect a limited impact of the liquidity additions the rest of Q2, since the surge ON RRP usage acts as a
counter-weight to the added liquidity and if the Fed decides to relax the criteria for the ON RRP facility even
further in June, then it only adds to this point. The eective amount of USD reserves in the system actually
dropped last week (due to the ON RRP surge), and we are still below the peak from week 15.

e-markets.nordea.com/article/65802/global-close-to-peak-usd-liquidity-abundance-receive-5yr-eurusd-xccy-basis
Chart 3. Stealth QT on the cards in Q3, potentially paired with a tapering decision

How to play it? Receive 5yr xCcy basis as a combo of a liquidity bet and a
macro hedge
The xCcy basis swap is probably the most “naked bet” on a reversal of USD liquidity trends (OIS/OIS
xCcy would be the clearest bet). The recent positive repricing of the entire EURUSD xCcy basis curve is a
consequence of the abundancy of USDs and it is starting to look almost historically cheap to receive the
EURUSD xCcy curve. When the Fed finally launched tapering in late 2013, it proved to be the first warning
signal of a reversal of the trend in the xCcy basis as well, which a subsequent year-long repricing of USD
liquidity following the decision (see chart 4).

e-markets.nordea.com/article/65802/global-close-to-peak-usd-liquidity-abundance-receive-5yr-eurusd-xccy-basis
Chart 4. Tapering = a more expensive USD in the xCcy basis?

The combination of a fairly strong USD and a cheap USD in the xCcy basis is historically a rare phenomenon
(see yellow dots in chart 5), hinting that the current combination of levels is a kind of sweetspot for hedgers
of USD assets. Furthermore, the xCcy basis is clearly correlated to global equity trends (currently 75%
correlated to MSCI World on a running yearly basis), which leaves receiving the 5yr xCcy basis as a decent
macro hedge from a portfolio perspective.

It is hence starting to look almost like a bargain to receive in the longer-dated xCcy basis as part of the FX
hedging program. You can find our latest xCcy quant book here.

e-markets.nordea.com/article/65802/global-close-to-peak-usd-liquidity-abundance-receive-5yr-eurusd-xccy-basis
Chart 5. Strong USD level and a cheap USD in the xCcy basis. A sweetspot for hedgers of
USD assets?

Andreas Steno Larsen

Chief Global FX/FI Strategist
andreas.steno.larsen@nordea.com
+45 55 46 72 29

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